Islamic Banking – What Is It and How Does It Work?

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Islamic Banking

Islamic banking is commonly called Islamic finance or shariah-compliant finance. It refers to finance or banking activities that adhere to shariah (Islamic law). Islamic banking’s fundamental principles are:

  • sharing of profit and loss

  • The prohibition of the collection and payment of interest (fee)

There are around 300 banks together with 250 mutual funds across the globe that go with Islamic principles of banking. An important fact to mention is that in 16 years (2000-2016), Islamic banks’ capital grew up to $3 trillion, whereas they started with $200 billion. Why? Because the economy of Muslim countries started to rise, mostly due to the increase in the oil price.

How Islamic banking works

Islamic banking relies heavily on the laws of Islamic faith when they are doing any commercial transaction. Naturally, they are rooted in the Qur’an (the main Islamic religious text). This means that any transaction in Islamic banking has to comply with shariah. What is Shariah? It is the legal code of Islam, based on what Qur’an teaches. Figh al-muamalat is the official name of the rules of commercial transactions made in Islamic banking.

Every banker that works by the Islamic institution has to respect the Islamic banking laws, and everyone puts faith in them to fully appreciate the ground principles of the Qur’an when they are doing business with clients. Islamic bankers will be helped by learned scholars if they need more information or guidance, but it’s common to use their intuition combined with independent reasoning.

The main difference

The primary difference between Islamic and conventional banking is that usury and speculation are strictly forbidden by Islam, or rather haram (unlawful). Shariah forbids anything that implies gambling or speculation, and that is called “maisir”. This means loans are prohibited as well.

How do you earn money then?

Is it possible to earn money without charging fees or any interest? Yes, and Islamic banks do that by using the equity participation system. This means if you take a loan for your business, you will pay it back without interest. But, this means you will have to give the bank a share in its profits. If you don’t make a profit, the bank will not as well. It’s important to mention that any investments that include anything prohibited in the Qur’an (alcohol, pork, gambling) are also haram (banned). Islamic banking can be considered as a form of ethical investing if we look at these examples.

How it all began

Islamic banking had started around the Medieval era when business people from the Middle East travelled to Europe because of financial transactions.

In the beginning, they used the same principles as the Europeans, but over time, trading naturally developed, and Europe started expanding their banks to the Middle east. While some adopted the culture and customs, where there was no profit/nor interest financial system, they succeeded in making an economic system that worked using a profit and loss sharing method. From that time, it wasn’t until the 1960s when Islamic banking started to be seen again in the world, meaning many interest-free banks were opened, mostly in Muslim countries. They also started operating in Western Europe during 1980. An interesting fact is that this banking system was developed by the Iran and Sudan government primarily.

Islamic Windows

Islamic window is a term that explains services based on Islamic principles that a conventional bank can provide. This means there are conventional banks that offer this type of service using windows dedicated to it. Along with banking, forex trade in Islam also has some differences compared to common practice.

In practice

In 1963 in Egypt, The Mit-Ghamr Savings Bank was established, and it’s often referred to as the first institution to do Islamic banking in the modern world. When they loaned money to various businesses, they used a profit-sharing model, but the bank closed four years later because of political reasons. Still, during its year of operations, the bank showed great caution and from all business loan applications approved only 40%. Still, the bank’s ratio was zero.

Islamic banking institutions tend to avoid risk when they make any investment, so you will rarely see them connected to any economic bubble.

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